Good day, ladies and gentlemen and welcome to Primo Water's Second Quarter 2016 Financial Results Conference Call. At this time, all participants' lines are in a listen-only mode to reduce background noise. Later, we will conduct a question-and-answer session and instructions follow at that time.

[Operator Instructions] As a reminder, today's conference call is being recorded.

I'll now like to introduce your first speaker for today Katie Turner. You have the floor.

By now, everyone should have access to the release that went out this afternoon at approximately 4:05 p.m. Eastern Time. If you have not received today's press release, it is available on the Investor Relations portion of Primo Water's website at www.primowater.com. This call is being webcast and a replay will be available on the company's website.

Before we begin, we'd like to remind everyone that the prepared remarks contain forward-looking statements including financial guidance and management may make additional forward-looking statements in response to your questions. The forward-looking statements should be considered within the meaning of the applicable securities laws and regulations regarding such statements.

Many factors could cause actual results to differ materially from those forward-looking statements and we can give no assurance of their accuracy and Primo Water assumes no obligation to update them. We encourage participants to carefully read the section on forward-looking statements included in the press release issued this afternoon and in all documents that Primo Water files with the SEC.

And now, I’d like to turn the call over to Primo Water's CEO, Billy Prim.

Billy Prim

Thank you, Katie. Good afternoon, everyone, and thank you for joining us today to review our second quarter 2016 results. I’ll begin today's call by providing a few highlights on our recent quarter and trends in our business. Then Matt will update us on the progress of our key strategies. Finally, Mark will review our financial information in more detail and our outlook for the third quarter and the remainder of the year.

Our business momentum continued in the second quarter of 2016. We generated record financial results above our expectations and we benefit from more households in the U.S. and Canada choosing to use our dispenser and trusted water solutions.

Total sales were record $34.4 million outpacing the high-end of our guidance. I am particularly pleased with the continued supply chain cost -- leverage in both our Water and Dispenser segments which led to a significant improvement in our gross margin to 30.3%. These results fuel adjusted EBITDA to a record $6.2 million for the quarter, a 39% increase over the second quarter of last year and above our guidance.

Primo remains well-positioned with the right product offering that on trend and resonating with consumers as they seek healthier beverages and safe quality drinking water.

In addition, we have the right team of dedicated employees all working towards the same mission, inspiring healthier homes through better water. We believe our teams' efforts over the last several quarters continued to pay off with sales of dispensers leading to new water households consuming either our refill or exchange water.

Our momentum helps to accelerate same-store unit sales growth in our U.S. exchange business of 9.7%. This is particularly impressive as we delivered this level of growth on top of 8.7% same-store sales increase in Q2 of last year. This also marks the 17th consecutive quarter of 8.5% or higher same-store unit sales growth in our U.S. exchange business. As a result of our year-to-date performance, we are raising our annual sales and adjusted EBITDA guidance which Mark will review in more detail.

In summary, we are very pleased with our operational and financial performance in the first half of 2016. At the end of Q2 we had approximately 26,300 retail locations and believe we can grow this number 50, 000 to 60,000 over the next several years. At Primo, we believe we are uniquely positioned in the marketplace to achieve success with the right people, products and strategies in place to support our future growth.

With that review, I will now turn the call over to Matt to discuss our key strategies in more detail.

Matt Sheehan

Thank you, Billy. As a reminder we have six key strategies that continue to drive our performance. First, grow household penetration of dispensers. Second, improve connectivity of our dispensers and our water. Third, increase retail outlets. Fourth, drive unit economics. Fifth, having highly engaged teams and lastly, doing all of these while living our company values.

I would like to provide an update on a few of these key strategies. First, grow household penetration of dispensers. In the second quarter, we continued to see the acceleration of dispenser sell-through, which was up 24% to a record 165,000 units. We are excited by this growth rate, especially given the increasing base upon which we grow and believe it is due to a few key items.

First, the increased consumer focus on healthy living and concerns over drinking water quality. Just this past quarter, CNN reported information from multiple sources stating that nearly 18 million Americans living communities with water system issues. Nearly 5,300 municipal water systems that supply these 18 million people were found to be in violation of the EPA's lead and copper rules.

These rules were in place to safeguard America's drinking water systems from the aging infrastructure. Worst yet, Flint, with water crisis has been well-documented, was not even on as reports violation list.

Second, our continued work with key retail customers to optimize the space dedicated to our offering and ensuring we have the right product assortment based on trends and demographics.

Third, our heightened focus on managing in-stock levels and constantly improving the quality and consumer experience over the dispensers. And lastly, we have made several changes to our dispenser model, such as lowering our selling price to retailers, introducing a broader assortment of lower cost dispensers and introducing a licensing model. All of this impacts selling revenue. However, it increases the number of households that use our water.

The second notable strategy is improving connectivity of our dispensers and our water. The record levels of dispenser sell-through helped propel 9.8% increase in overall water sales. This is an acceleration over the first quarter, and we believe this demonstrates how increased dispenser sell-through is driving water sales.

We are increasing our focus on ways to connect consumers to our water, at a point of initial purchase of a dispenser. For instance, within the quarter, we partnered with a leading home improvement retailer on a Memorial Day Weekend promotion, including free water with any dispenser purchase.

We are pleased with the results of this promotional test that led to a substantial lift in dispenser sales, and we believe this will create a long tail of recurring water purchases. We will continue to be both strategic and opportunistic in partnering with our retail customers on similar promotions.

Next, increased retail outlets. During the second quarter, we added 300 net retail locations, the majority being Walmarts. And over the last year, we've added approximately 1,600 overall locations. We continue to work with Walmart on a significant expansion of both dispensers and exchange.

Retailers are seeing the impact of the situation in Flint, Michigan, and other water quality issues and are committed to providing both water solution and dispensers to their customers.

Finally, drive unit economics. Driving unit economics comes from increasing unit revenue, reducing operating cost and decreasing capital spend per installation. As it relates to unit revenue, we will continue to focus on gaining productivity from existing location, which is much more valuable than a new location.

We continue to analyze and test tactics at our existing stores to drive improvement through optimal in store placement, refreshing display equipment, signage and promotion such as the Memorial Day promotion mentioned earlier.

Additionally, we are working with retailers to drive a clearer message and point-of-purchase and more than one Primo product is available in store. Finally, we continue to test several items such as in store communication methods and messages, seasonal marketing initiatives and dispensers, dispenser pallet promotions and our online presence.

Moving onto operating costs. The second quarter continue to demonstrate the availability of incremental leverage to improve cost of distribution and exchange operating efficiencies and refill and cost improvements in dispensers

In summary, we are pleased with our execution and excited about the opportunities ahead as we continue to focus and deliver on our key strategic initiatives.

With that, I'll turn the call over to Mark to cover our financial results.

Mark Castaneda

Thanks, Matt. I will review our second quarter financial results in more detail then I'll provide third quarter guidance, followed by an update on our annual guidance. Lastly, I'll turn the call back over to Billy for closing remarks.

To help investors understand our operating results, we do provide adjusted EBITDA and pro forma EPS, which are non-GAAP financial measures. A reconciliation of these can be found today's earnings press release posted on our website.

We are very pleased with the results from our second quarter, which exceeded our guidance on both sales and adjusted EBITDA. Our second quarter topline grew 6.1% to a record $34.4 million driven by our Water segment.

Water revenue increased 9.8%, primarily due to 13.2% growth in our U.S. Exchange business and 5.3% growth in our U.S. refill business. During the quarter, our U.S. Exchange business experienced an acceleration in same-store unit growth to 9.7%.

Dispenser revenue decreased slightly to $10.1 million from $10.3 million, due to factors that Matt previously discussed as well as timing of orders from major retailers compared to the prior year.

Moving down the P&L. Gross margin expanded 500 basis points to 30.3% compared to 25.3% in the prior year period. The significant improvement in gross margin is due to our continued supply chain cost improvements as we generate greater leverage across our fixed costs at both our Water and Dispenser segments.

We believe these improvements will remain near these elevated levels throughout 2016. Additionally, we benefited from a great a mix of higher margin of Water sales during the quarter.

Next, SG&A increased $4.8 million from $4.3 million in the prior year, and interest expense for the quarter decreased 3% to $500,000. Adjusted EBITDA increased 39.1% to a record $6.2 million from $4.8 million in Q2 of last year, which illustrates the leverage and high quality of earnings in our model when compared to our topline growth of 6.1%.

On a GAAP basis, net income more than tripled to $2.3 million and diluted EPS increased to $0.08 from $0.03 in the prior year. Our pro forma fully diluted EPS was up $0.11 from the $0.05 in the prior year.

Continuing onto our balance sheet, we ended the quarter with $1.6 million in cash and we have $15 million available under our revolving credit facility. Our total leverage ratio at the end of the quarter is below one times EBITDA, which has improved significantly over the past couple of years as we substantially increased our EBITDA performance and paid down debt. Also, $4 million became current under our terms of our credit facility as a result of scheduled payments in June of 2017.

Turning to our outlook. For the third quarter and remainder of 2016, we expect sales for the third quarter of $33.9 million to $34.9 million. In addition, we are raising the high end of our outlook for 2016 sales to a range of $132.2 million to $134.3 million.

We expect adjusted EBITDA for the third quarter of $5.9 million to $6.3 million or an EBITDA margin of 17.4% to 18.1%, which is up compared to the prior period -- prior year period.

Based on our performance today, we are raising our outlook for 2016 as we now expect adjusted EBITDA to be in the range of $21.9 million to $22.6 million. We continue to expect interest expense to be approximately $2 million and CapEx in the range of $10 million to $12 million, resulting in free cash flow between $7 million and $10 million for the year.

I will now turn the call over to Billy for closing remarks.

Billy Prim

Thanks Mark. We are very pleased with our second quarter results and excited about the future. We appreciate the efforts of our dedicated employees, service providers, retail partners. Together, we are executing on our mission of inspiring healthier homes through better water. We remained intently focused on the execution of our strategic plan to further grow our business and enhance long-term shareholder value.

This concludes our prepared remarks. We are now ready for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Reed Anderson from Northland. Your line is open.

Reed Anderson

Hi, good afternoon and congratulations. You guys just keep pounding out the good quarters.

Billy Prim

Thanks, Reed.

Reed Anderson

So I wonder -- a couple of questions, I guess. I wanted -- I have a little more and may be started Matt into this promotion you talked about around Memorial, very intriguing obviously you had a nice impact, I wonder if you could just provide a little more color on that either on the number of locations kind of what you felt that might have contributed, just trying to get a sense of how important that might have been, even the results are -- I am trying to figure out your ability to continue to drive business with events like that?

Matt Sheehan

Great question. I would say with this was isolated to one client so far, and I call it a test that was successful. Again, the test itself was where we gave a free bottled water with every dispensers sold over a short timeframe. And these are things that we can execute again, but I call it test, and it did have a bump to the business. And again, we will continue to think about promoting the razor because we do believe it has a long tail for that business, but this is with one client in a very short time period, but we will continue to look at those in the future.

Reed Anderson

And was it broad-based for the client, or was it isolated in some particular regions, geography that kind of thing?

Matt Sheehan

This one was broad-based.

Reed Anderson

Okay. That's great. Good. Good. And then question again, just quickly, Mark on margins, I continue to just see great expansion on the gross margin, you know, practically double with the last quarter. And my perception is that we're kind of level off in here and call it kind of 30s, low 30s. I just want to make sure that's what you meant when you said you kind of consistent or did you mean that we should basis point increases like we did in the last quarter, just want to make sure I am clear on that?

Mark Castaneda

Yeah, I believe we will be consistent kind of at the levels we are today. There is some seasonality to our margins. So as dispensers become a bigger portion of the mix, the margins come down a hair. But as third quarter, which typically has a high mix of watermark -- water, you have a slightly higher margin.

Reed Anderson

Okay. And then just to carry the thought further, I am not looking for specific numbers, but as we look then in the next year, coming off a year you had a huge expansion and do you still believe there's opportunities to expand margins? Just obviously not quite at the rate we saw this year or is this kind of a one done sort of deal?

Mark Castaneda

So, we do believe there's additional room to grow margins as the volume grows.

Reed Anderson

Good. That's all for you. I will let someone to jump in and I'll come back later. Thanks guys. Good luck.

Operator

Thank you. Our next question comes from the line of Matt Blazei from Lake Street Capital. Your line is open.

Matt Blazei

Hey, guys, great quarter as usual. I have a quick question. I know you have a very tough comp in the dispenser side from last year, is that's what's driving sort of the flattish to up 3% sort of guidance for the revenue line in the quarter for Q3?

Mark Castaneda

That is. Matt, this is Mark. Yes, we do expect dispensers actually to be down on the selling business from a revenue standpoint. We do expect strong continued sell-through, but from a selling standpoint, we do expect them to be down next quarter.

Matt Blazei

Okay. This is sort of an anomaly given with that last year's quarter was so strong.

Mark Castaneda

Yeah. And then dispensers are lumpy. So.

Matt Blazei

Right. I understand. And then on the -- when you said that there were 165,000 sold in this quarter, can you give me some perspective on what that looks like say versus a year ago?

Mark Castaneda

Yeah, second quarter of last year was around 133,000.

Matt Blazei

Got it. Okay. I think in the last call, you said you thought you might add 1,500 to 2,000 locations let's say in this year, I think you have added about 600 so far. Do you see the acceleration in the back half?

Matt Sheehan

We continue to look at that 1,500 to 2,000 number. We've added 1,300 locations over the last year, and we think that 1,500 target is still good.

Matt Blazei

For 2016?

Matt Sheehan

Yeah.

Matt Blazei

Got it. And is that because of the promotion -- is that because of the acceleration for Walmart? Or is there any particular reason why you are expecting to add some more units in the back half?

Matt Sheehan

Again, we're talking total numbers, right? We, obviously, have some consolidation that will impact that number, but we are growing fairly well with Walmart.

Matt Blazei

I see. So that's 1,500 to 2,000 net number, it's just new adds.

Matt Sheehan

Correct.

Matt Blazei

Got it. Okay. I understand. All right. That's good for me. I appreciate it. Thank you.

Operator

Thank you. [Operator Instructions] We'll take our next question from the line of Mike Petusky from Barrington Research. Your line is open.

Mike Petusky

Good afternoon guys and I will add my congratulations on the performance for the second quarter. I guess my first question is around actually the retail adds in the back half. How many more Walmarts? I know you had a bunch kind of teed up to do in 2016, how many more do you have to do kind of in the back half that are kind of teed up as the first 500, 600 were?

Matt Sheehan

And Mike, we're still working on some of those numbers. But we -- what we usually see 200 plus locations from Walmart coming at the back half of the year.

Mike Petusky

Okay. Will most of them come in the third quarter, or kind of split or?

Matt Sheehan

It’s -- we're still working on that plan right now.

Mike Petusky

All right. And then I guess I just had a question, because I do -- simply don't know, in terms of what you guys do, when you describe your online presence, I mean, do you get much action from online? And what you actually do there in terms of marketing?

Matt Sheehan

We haven't done a ton of marketing quite yet some we're working on both in our own online presence and with retailers. But we are traditionally with our dispenser lineup, we are on.com in most of our retailer partners. And then we continue to work on our own presence online. Today, it's a small part of the business that we see growing and we'll kind of continue to put some efforts against that.

Mike Petusky

Okay. I mean, do you see that as ever being a meaningful part of attracting customers or not really?

Matt Sheehan

We think it can be more meaningful than it is today. So, yeah, I think it is a good avenue for some consumers to get a dispenser sure.

Mike Petusky

Got it. All right. And I guess, I think I've asked this question previously, but you guys continue to generate good cash flow, continue to de-lever, are there things out there, are things that, you know, valuations of assets getting more interesting, can you just talk about potential external growth as you look out over the next say 12 to 24 months?

Billy Prim

Yeah. I'll answer that. As we said before, our businesses are doing very well. And we want to continue to invest in our core businesses. We are a growth business and we want to make sure we have a capital to continue to invest in those businesses, and that's what we plan to do.

Mike Petusky

Got you. Okay. Very good. Thanks, guys.

Operator

Thank you. Ladies and gentlemen, this now concludes our today's question-and-answer session. I'd like to turn the call back over to management now for closing remarks.

Billy Prim

Thank you. Thanks for your participation on today's call and your interest in Primo Water. We look forward to providing you an update on our business progress when we report the third quarter earnings in November. Have a great evening. Thanks.

Operator

Ladies and gentlemen, thank you again for your participation in today's conference. This now concludes the program, and you may now all disconnect at this time. Everyone have a great day.

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